The following is meant to be a brief introduction to the world of CMBS. We promise to make it light and not (too) boring. Enjoy.
CMBS STRUCTURE OVERVIEW
In its simplest form, a CMBS security is a vehicle that gives investors the rights to debt payments made from a group of commercial loans. In any particular CMBS security, a diverse group of loans pays debt service to a trust. The Trust passes through those debt service payments to the security and in turn, the investors. The security itself is divided into multiple different levels of bonds which we call tranches. Each tranche has a different credit rating and a different set of attributes. Investors can choose which tranche they want to invest in based on risk and yield. It is important to note that senior rated tranches get paid first while junior rated tranches get paid last. However, senior rated tranches receive a lower yield than junior rated tranches.
Tranching is key to understanding how CMBS investors are compensated. As we mentioned above, senior bonds are paid first but receive the lowest yield while junior bonds are paid last but receive the highest yield. Being “paid first” vs. “paid last” simply means that, in the event of a default where a loan or a group of loans can’t make their payment and there isn’t enough money to compensate all bondholders, senior bondholders receive full payment while junior bondholders receive short or no payment. Credit support of a particular tranche is simply the percentage loss a the entire security can experience before that tranche loses its principal. In the example above (Security CSAIL 2019 C-16) Tranche B has 17.92% of credit support meaning the security has to lose 17.92% value before Tranche B loses it’s principal.
Bonds are rated by rating agencies such as Standard and Poor’s, Moody’s, Fitch, and DBRS. Ratings are assigned based on a variety of statistical data compiled and interpreted by rating agency analysts.